UNEMPLOYMENT AS A HIRING PROBLEM Robert J. Flanagan CONTENTS Introduction ............................... 124 1 . What is different about the European unemployment experience? . 125 Unemployment flows ........................ 126 II . The failure of supply-side explanations ............... 127 111 . Hiring decisions and unemployment ................. 129 A . Fixed employment costs .................... 129 B. Uncertainty about employee quality .............. 130 C . Uncertainty about future demand ............... 132 D. General implications of the "reluctance to hire" view ..... 133 E . Hiring relationships ...................... 144 Conclusions ............................... 147 Annex: Sources and definitions .................... 151 Bibliography ............................... 152 The author is Professor of Labor Economics. Graduate School of Business. Stanford University. Stanford. California. This paper was prepared as part of a consultancy for the OECD .The opinions expressed herein are those of the author and should not be interpreted to reflect the views of the OECD or its Member Governments. The author is grateful to Janice Callaghan and Rita Varley for research assistance and to David Coe. Franpoise Cor6. David Grubb. John Martin. Franciscus Meyer.zu.Schlochtern. and participants at a seminar held at the OECD for helpful comments and assistance. 123 INTRODUCTION The rise in unemployment in OECD countries during the 1970s and 1980s remains one of the central concerns of economic analysis and policy. Within the general growth of unemployment are several varieties of unemployment experience, however. For example, developments in the 1970s and 1980s reversed one of the previously accepted facts of comparative macroeconomics: average unemployment rates in Europe, which were persistently lower than in the United States before the 1970s, have been persistently higher in the 1980s. Moreover, there is significant variation in the unemployment experience within Europe. Unemployment rates remained low and increased only modestly in some smaller European countries (such as Norway, Sweden and Switzerland) while unemployment rates doubled and tripled in other countries. Recovery from high unemployment levels has also varied among countries. In North America, Japan, and the same smaller European countries unemployment is currently below rates attained at the previous cyclical peak, while in most of the larger European countries, unemployment is still close to its highest post-war rate. Only in Norway, however, have job vacancies and business survey indicators of labour bottlenecks returned to peaks reached in the late 1960s or early 1970s. Recent research attributes the rise of unemployment in the larger European countries to three factors in uncertain proportion: deficient demand, high real wages, and (in many countries) increasing maladjustment in the labour market, signalled by an outward shift in the Beveridge curve and a rise in the non-accelerating inflation rate of unemployment (NAIRU) (Bruno and Sachs, 1985; Bean, Layard, and Nickell, 1986; Flanagan, 1987b)’. In recent years, however, some factors associated with the rise in European unemployment have reversed without a corresponding decline in unemployment rates, suggesting that different factors may account for the growth of unemployment and for its persistence. This paper focuses on the last of the three factors mentioned above. In principle this presents a large agenda, since there are many potential sources of increased maladjustment in labour markets. Virtually anything that alters the incidence or duration of unemployment in equilibrium will shift the Beveridge curve. Thus, changes in the various incentives influencing job search and the matching of workers to jobs should ultimately influence equilibrium unemployment, and some discussions of European unemployment in the 1970s and 1980s have stressed the role of 124 unemployment insurance (which subsidises unemployed job search), rigid relative wage structures and other factors that may impede labour mobility. There has been little attention to the effects of changing incentives on the demand side of labour markets, but as will become apparent, these can be an important source of maladjustment as well. Sections I and II of the paper use existing evidence to narrow the class of admissible explanations for the unemployment experience in large European countries compared with North America and Japan. The first section develops the unique features of the unemployment experience in these countries which an explanation of labour market maladjustment must capture. Earlier research into labour market maladjustments examined hypotheses pertaining to the supply side of labour markets. This research has shown that factors such as structural barriers to mobility and increased unwillingness of workers to accept jobs can account for very little of the increase or the persistence of European unemployment. The evidence on this point is reviewed in Section 11 of the paper. Recently, a new view of unemployment as a hiring problem has emerged from both theoretical and empirical research. According to this view, the key question behind the structural element of unemployment growth is why European employers are more reluctant to hire at any given vacancy rate - not why workers are more reluctant to accept jobs. The third and main section of the paper presents the analysis and evidence pertaining to this view of the European unemployment problem. I. WHAT IS DIFFERENT ABOUT THE EUROPEAN UNEMPLOYMENT EXPERIENCE? Two factors differentiate unemployment in large European countries from unemployment elsewhere: its persistence and the behaviour of unemployment flows. Unemployment in major European countries increased in two dramatic steps following the first and second oil shocks. Since OPEC II, however, high unemploy- ment has persisted despite a reversal of many of the factors that have been linked to its rise. The persistence phenomenon is further signalled by evidence from many countries tending to undermine the conventional analytical dichotomy between actual and equilibrium unemployment: in the 1970s and 1980s, the equilibrium rate of unemployment appears to have followed the actual rate of unemployment (Coe, 1985). One current interpretation of this observation is that the equilibrium unemployment rate is a function of the path of the actual rate, reflecting a kind of hysteresis in labour markets. In this view, a shock that raises unemployment sets in 125 motion labour market mechanisms that tend to perpetuate higher unemployment. For example, if longer spells of unemployment produce a deterioration in the stock of human capital and employers use the length of unemployment as a screening criterion, the equilibrium rate of unemployment will rise. Alternatively, hysteresis could occur because those who remain employed have sufficient bargaining power to set wages at levels inconsistent with re-employment of the unemployed*. An alternative view, more in the spirit of parts of this paper, is that specific institutional developments in labour markets during the 1970s effectively raised equilibrium unemployment independently of the behaviour of actual unemployment. If this view of the basis for persistence is correct, a fall in equilibrium unemployment must await specific institutional changes. Persistence has not been a major aspect of unemployment in the United States, where unemployment, which peaked at 10.5 per cent in late 1982 dropped below its 1978-79 level in 1988. By 1988, unemployment rates in Nordic countries were also below their 1979 levels (OECD, 1988b, Chapter 1). Unemployment flows The change in unemployment over time is the difference between unemploy- ment inflows and outflows. The presumption that a secular increase in unemploy- ment results from an increase in inflows to unemployment from layoffs, quits, and labour force entry is supported by studies of unemployment flows in North America, Japan, and Australia (Darby, Haltiwanger and Plant, 1986 and Gregory and Foster, 1982). The situation has been very different in Europe, however. Studies of France, Germany, and the United Kingdom find little secular increase in flows into unemployment but a rather substantial decrease in outflows from unemployment (Barge and Salais, 1984, Flanagan, 1987b, Pissarides, 1986, and OECD Economic Surveys, 1986b). Indeed, these studies indicate that the decline in the likelihood of leaving unemployment by obtaining a job or leaving the labour force has been the main source of the secular increase in unemployment in larger European countries. The pattern of unemployment flows has implications for the duration structure of unemployment, which are now widely recognised. Economies where job seekers have experienced a secular decrease in the odds of leaving unemployment are characterised by increasingly long-duration unemployment in comparison with those in which the rise in unemployment results mainly from increased inflows. Thus, the incidence of long-term unemployment is much higher in the larger European countries than elsewhere. In 1987, for example, the proportion of unemployment lasting more than one year was 45.5 per cent in France, 32.0 per cent in Germany, and 42.6 per cent in the United Kingdom. Elsewhere the proportion was 8- 10 per cent in North America, 7-21 per cent in Austria and the Nordic countries, and 17.2 per cent in Japan (OECD, 1988b, Chapter 2, Table 2.8). 126 The character of European unemployment flows also channels